There is perhaps no unit of account more misunderstood than cash value. The ‘net present value of a future guaranteed payment’ simply does not register with us the way other representations of value do. Yet a working knowledge of what cash value is and how we utilize it is crucial for understanding the process of IBC. In this post, we will try to contextualize what cash value actually is with examples so we can better understand this unique asset.

What Cash Value is Not

Let’s start with what cash value is not. It is not a checking or savings account set aside for your use at the life insurance company, though that is our natural first thought as it is what we are most familiar with. It is not an investment portfolio that grows if the market grows, nor is it a money market fund. Given that such accounts comprise the remainder of our balance sheet, what else could it be?

We must start with the death benefit, as there can be no cash value without a death benefit. In a permanent life insurance contract (as compared to a term policy), the company is contractually obligated to pay a specified death benefit at some point in the future. Given that our death is a certainty, this payment then becomes a certainty as well. The company does not get to back out of this obligation so long as we pay our premium (thus whole life insurance is a unilateral contract). This certainty gives both the company and the policy owner (or one day the beneficiary) the ability to plan for and account for this future exchange of capital in the present and at any point in the future of the contract.

In an overly simple example of how certainty of future payment can translate to value in the present, imagine that you are considering undergoing significant home renovations. You look at the $60,000 estimate from the contractor and wonder if you can afford it. You have one week to give him an answer. Consider as you read this your current financial picture; think about where you might find the capital for such a project and how you might have to move money around to find the liquidity. Assuming that an expense of this magnitude would be a major undertaking for all those reading this post, responses might range from ‘absolutely not’ to ‘I could probably make it work.’ We’ll also assume that this is a renovation you very much want to make, so choosing not to fund it would be strictly due to an inability to find the money. Note your current assessment of the feasibility of this project, then consider another factor which we’ll inject into the scenario.

You now find out that an uncle recently passed and left you $250,000 from his estate which the trustee of his estate assures you will show up in your bank account in two months. How would this change your decision calculus? With the foreknowledge of a guaranteed future payment, you are able to make decisions in the present which you might not otherwise be able to make? This is an abridged way of demonstrating that future economic certainty imparts quantifiable benefits in the present, before it is actually realized.

The challenge then comes in actually quantifying that value in the present. This is where actuarial math comes into play. Actuarial science is the application of mathematical and statistical methods to the systematic observation of natural events (in this case, death) to assess the risk of such events occurring. The actuaries at a life insurance company use this science to measure risk and price their products appropriately such that the company can fulfill its obligations but remain profitable. The primary liability they must account for is paying out death benefits to beneficiaries that are many multiples of total premium received. This would quickly bankrupt a company if not for a mathematically sound distribution of risk in accordance to observable mortality statistics. They need time to grow the pool of premiums paid into much larger payout amounts, and they secure themselves this time by ensuring that their underlying risks are appropriately priced and stratified such that the expected rate of mortality does not adversely impact the larger pool of capital.

For example, a healthy, non-smoking 35 year old male will be pooled with other similar rated individuals, to which the actuaries will apply the expected mortality rate to estimate the number of claims that will likely be paid out in the future. We know that each of these claims will eventually be paid out, but we also know (or more accurately, we have very precise models to estimate) that these will be spread out over many years, allowing the capital to grow in the meantime. Each year that passes, that pooled tier of insured lives ages and their expected number of deaths increases. When that same pool is 70 years old, many more claims will be paid out than when they were 35, obviously. The spreading of risk over a large pool and along a long timeframe is the foundation upon which the theory of insurance is built.

This speaks to the power of time in the growth of cash value, but we need to hit the math a bit harder before coming back to that point. Policies must have a uniform future age of maturity to set a standard by which to measure backwards to determine present value. In the U.S. that age is 121 (increased from 100, which is what Canada still uses); if an insured were to reach age 121, their policy would be fully matured and the company would simply hand the death benefit proceeds to the insured rather than to the beneficiaries that would otherwise have gotten it had death already occurred. It should then make sense why the cash value on the illustration, which is flowed out to age 121, is equal to the death benefit in that year. But where did they get all the cash value numbers in the meantime?

Meat on the Bone 

To borrow an example from economist and fellow IBC practitioner Ryan Griggs, let’s say you were to purchase a $1,000 television at Best Buy with a 30 day return policy. You paid the full $1,000 and took it home, but decided it was not a good fit for your living room. When you return it to Best Buy, they would refund you the entire amount you paid. However, if you purchased it on a four payment installment plan, paying $250 at purchase and committing to three more future payments, would you expect a refund of $1,000 when you returned it a week later? Of course not, for you had not ‘paid up’ the television; you would only get back your current ‘equity’ in the purchase, not the full value.

Take a mortgage as another example. You signed a contract to pay thirty years of payments to the bank, so if after a few years you decide to sell the house, you do not get the full sale price, as you have yet to pay off the house entirely. If you purchased the house for $500,000 and had paid a decade of mortgage payments, you might have attained $100,000 in equity. The bank would still hold the note for the remaining $400,000, assuming the value of the house remained the same. Your equity (aka your net present value) is not the full value of the home, as more payments are required in order to gradually shift ownership of that value to you.

In a common attack on IBC by economic illiterates (like Dave Ramsey, at least so far as it comes to his understanding of whole life insurance), they make the nonsensical statement that when you die, the ‘greedy life insurance company gives your beneficiary the death benefit, but they keep the cash value.’ They are demonstrating that they know less than you now do about what cash value is. If we use the mortgage example, that would be analogous to selling the house at the ten year mark as noted above, but being angry that we didn’t get the $500,000 sale price and our $100,000 equity. “But I had equity already, where is that check?” would be like your beneficiary saying “But he had built cash value already, where is that check on top of the death benefit?” It’s quite simple to understand why that question is inconsistent with the basic definitions of these terms, so the question must be asked: is it mere ignorance, or intentional deception, that leads to such uninformed criticism?

Let's take one more shot at a mathematical example to drive home the concept of present value. Pick up your phone and pretend it is a promise to pay. Whoever holds that bond (your phone) in one year will receive from the bond issuer a check for $10,000. Maybe we say the Verizon store is the issuer, and they've promised that one year from today, they will exchange that phone for a check to whoever brings it in. We know that the phone is worth $10,000 in a year, but what is it worth today?

If you were to offer a friend the right to purchase that contract, what price would you take today? They obviously wouldn't pay you the full $10,000 because they would simply be losing control of that money for a year with nothing to show for it when they turn in the phone. You would also have a floor on the range of offers you would accept- why would you take $2,000 when you don't think you can grow your money 500% in a year to match your otherwise guaranteed return? You'd just wait a year and collect the full amount. But perhaps you would take $6,000 now, preferring to have that cash in the present to utilize and grow. We may all have a different number that we would accept for the phone, and we all may have different numbers we would offer someone else for the phone. It depends on our time preference of money- how soon we want to use it- that would determine the discount we would accept or offer. What is for certain though is that the value today, a subjective price, is less than the value a year from now, an objective price.

Let's carry that further and say that six months have passed. If you would have sold it to a willing buyer at $6,000 a full year from maturity, you certainly wouldn't sell it for $6,000 six months later, when you are that much closer to maturity. Again, what you would accept for it now would still be subjective, but it would objectively be a higher number than you would have taken on the initial offer. You were willing to forgo $4,000 in the future in order to have the $6,000 now, but that discount no longer makes sense when you have cut the time you must wait in half. You might still offer it at a discount in order to have cash in hand now, but the discount would be less. Perhaps you'd take $8,000 for it today, forgoing $2,00 in the future.

Let's throw in one more wrinkle. Now we'll say that the holder of the phone must pay $50 per month to keep the contract in force. If we are a twelve months from maturity, that means that to keep my future payout intact, I must plan for an additional $600 total outlay. If it were worth $6,000 to me to purchase the phone now in order to secure my $10,000 future payout, the added monthly payment required would have to be factored in to my calculus. What was worth $6,000 without the payment is necessarily worth less to me given the obligation that comes with the contract. So perhaps it is now worth $5,400 to me instead.

These concepts can help us begin to piece together what cash value is and how it is measured. Without getting hung up on specific numbers, I hope this helps crystallize in your mind the concept of present value. If you think of the phone as the death benefit payout, the amount that we determine the phone is worth in exchange today would be the cash value. That value would be offset by obligatory outflows, which for our purposes would be the premium payments. If you think of the schedule of future premium payments that you committed to in signing the policy, it should make sense why your ‘equity’ in the policy is not fully realized the day the policy goes in force. We know the company has a liability on their hands, namely that they must grow premium dollars in into a much greater amount of death benefit dollars paid out one day. They don’t know when that payout will occur, but they know that it will, and they know they must meet that obligation. If they owe my wife $2,000,000 at some point in the future, what is that future amount worth today? ‘What would they pay me to relieve them of that $2,000,000 bill?’ you might say. This is why cash value is also known as ‘cash surrender value,’ the amount you would walk away with if you decided to terminate the policy.

(As an aside, if you ever consider surrendering your policy to the company and be done with it, talk to us first; there is a market of buyers likely willing to pay more than the surrender value, as they understand the potential value of an in force policy which has paid through the early year cash drag.)

If I am age 120 and I know the $2,000,000 is due in a year, I would not accept much of a discount, as the net present value is very close to the value in one year. On the other hand, if that date is sixty years away, the discount I’d be required to take (if for some reason I wanted out) would be much greater. There is a much more specific method for calculating this amount using actuarial science and measuring exposure, called net amount at risk (NAR), but I want it to click conceptually rather than technically. If I still have several decades of premiums to pay into the policy, the company’s NAR is going to be higher than if I am done with premiums and have paid the scheduled contributions to the policy in full. They will pay that death benefit when I die regardless of NAR, but their exposure scales inversely with the number of premium checks I write. Every premium check I write, they get another chunk lopped off their total exposure, which they then are able to deploy and grow to fulfill that future guaranteed payment.

 If the above makes sense, then it becomes evident that the passage of time itself is a powerful driver of cash value growth. The other primary driver is premium paid into the policy, as each one reduces the future scheduled premium the company is expecting (actuarially, that is) to receive. Again, they will pay in full regardless of when you leave this earth, but the longer you’ve paid in and the more time they have to grow that input into a larger output, the less exposure there is for the company. If the actuaries have done their job and priced the risk correctly, those who die early and account for that larger exposure are balanced out by those who live full lives. All beneficiaries were paid, but risk was spread over time among the large pool of insured lives such that the company can meet all obligations without exhausting their capital.

Harness the Power of Time

We tend to visualize any dollar denominated asset as an account balance that we can dip in and out of, but as I mentioned at the beginning, cash value is not that. The insurer has a giant pool of capital into which premiums flow, and out of which come the cost of both keeping a business going and meeting liabilities (paying out death benefits to beneficiaries). The cash value on your account is not a separate account of capital on hold for you, but rather your legal claim on a small chunk of that total pool. You have first rights to that amount if you opted to surrender your policy and walk away with your cash (surrender) value. You also have unrestricted access to borrow against that amount in the manner that we use in practicing IBC. The mechanics of a policy loan is a fantastic discussion you can find on this blog; here I simply want to differentiate the derivation of cash value from that of the unit of account of the other assets on your balance sheet.

Regardless of whether or not you collateralize that cash value by borrowing against it, it will grow contractually guaranteed due simply to the passage of time as we slowly but steadily chip away at the time remaining till full maturity. It is for this reason that you might have heard us or another IBC practitioner say something along the lines of, “no matter what the market does, I can say with 100% certainty that my cash value will be higher tomorrow than it is today.” The company is not staking my cash value to their investment performance and subjecting it to risk, as again I am the first line secured claimant on my little chunk of the overall pool of capital. Even if the investment team underperformed, my cash value grew because it is contractually and actuarially necessitated to do so. Add to that growth annual premiums paid and the practice of using dividends to purchase additional death benefit and you should be able to come around to a modest understanding of what cash value is and how it is unique among the totality of the assets in your balance sheet.

The two types of premium, base and paid-up additions, is a very important distinction in function and contribution to both cash value and dividends, but that is for a future article. As Canadian IBC practitioner Jason Lowe says, ‘cash follows the leader.’ If you think of a race where one contestant gets an enormous head start, but the other must catch up and exactly tie the one with the head start, how much of a head start would want him to have? If your cash value is that second contestant, and you know one day he has no choice but to catch up to the death benefit (the one with the head start), you would want the first contestant to be as far down the track as possible, since that only ensures a larger volume of growth during the race. The primary takeaway, if you now feel like you better understand what cash value is, should be that the earlier you start this process, the more guaranteed growth you enjoy. The reality is that I will never be 35 again, and if I had not paid premium that year, it is not time in force that I can recreate. The best time to plant a tree was twenty years ago, the next best time is today. Wherever you are at, there is a powerful contractual growth engine waiting to be built, but time marches on. This reality cuts both ways, and we hope you put in force a system to capture the upside of the unavoidable passage of time.